Doc Maher answers UPod's questions.

THE PLAY - The Covered Call 

To learn more about Covered Calls, please check out Play #6 of The Options Playbook located in TradeKing's Learning Center.

ALL-STAR COMMENTARY - by Doc Maher

UPod has been selling calls six months out for his covered call plays. UPod explained: "...the main reason I sell calls with a longer expiration is due to the higher premium that comes with a greater amount of time decay. I'd appreciate your thoughts / insight into this logic (especially if it's flawed)."  

"Flawed" is probably not the right the way to look at it, I would say "not optimal." The covered call strategy tries to capture the time value of the option that you sell. So the quick answer you will usually get is that options time decay faster as they get closer to expiration. This is the reason that the more common way of setting up a covered call is to use the shortest time available. Exactly why is that important? Longer term options have a higher premium so isn't that better?

Although most practitioners of the covered call strategy understand this I want to explain in more detail why it is the preferred method.

To illustrate exactly how this trade off works out, I have constructed a couple of charts of Theoretical Option Prices versus Time. These are based on a $45 stock and the at-the-money option (ATM). The curves were created using the Black-Scholes model with the following parameters:

          Stock price $45

          Strike price $45

          Risk Free Interest rate 3%

          Implied Volatility 30%

All the parameters except for time remain constant, which simply means that the stock stays at $45 and the IV stays at 30, etc.

The first chart shows two options, one has 60 days to expiration and the other has 30 days. Most option players will be familiar with the shape of these.

Click here for a larger image.

This chart shows the "classic" time decay curves. The 30 day call starts with a premium of $1.60 and is worthless at the 30 day mark. The 60 day call starts with a premium of $2.29 and is worthless at the 60 day mark. So the 60 day option has a larger premium, $2.29 against $1.60. However in the first 30 days the 30 day option has decayed out the entire $1.60 while the 60 day option has only decayed out $0.69 to $1.60.

When you think about it this makes sense because at the 30 day mark, the 60 day call now has 30 days left. At this point it should be exactly the same price as the 30 day call when we started. And we can see that in the second 30 days the 60 day option is exactly the same as the 30 day option was after the first 30 days.

So if we write (sell) a 60 day call on this hypothetical $45 stock, we would collect $0.69 for the first 30 days and $1.60 for the second 30 days for a total of $2.29. If we had sold a 30 day call we would have collected $1.60 for the first 30 days, then sold another one for $1.60 and collected a total of $3.20 for the 60 days instead of only $2.29.

So what happens when we go out six months? The chart below shows a 185 day call versus a 30 day call under the same conditions as above.

Click here for a larger image.

As we can see the 30 day option decays from $1.60 to worthless in the first 30 days as before. However the six month call, which starts at $4.15, only decays $0.38 in the first 30 days to $3.77. According to this model we could write six of the 30 day options, each for $1.60, in the six months it takes for the six month call to lose its $4.15. That's 6 x $1.60 = $9.60 in premiums over six months versus $4.15 for the six month call.

So UPod here is your answer. To restate it, the short term options lose more time value over a given period than longer term options. This is why short term options are often used in the covered call trade.

I hope this helps clear things up.

--Doc Maher

"Income Trader"

DocMaher Trading LLC

All-Star Commentator

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Nicole Wachs contributed to this blog.

Options involve risk and are not suitable for all investors.

Please read Characteristics and Risks of Standardized Options.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Jonathan F. Maher, PhD has a professional business relationship with TradeKing.

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